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In these market-rattling, credit-crunching, confidence-sapping times, cash can be a very good thing for a company to have (although return-hungry shareholders might argue over how much). And indeed, Corporate America has amassed an impressive hoard over the past few years, as profits have soared. Yet, according to a new study done for CFO magazine, companies could be generating billions of dollars more in free cash flow. How many more billions? In theory, as much as $508 billion.

That eyebrow-raising figure comes from REL, an Atlanta-based global research and consulting firm. Seeking to find out how efficiently companies generate cash from sales, REL analyzed the 2006 financials of the largest 1,000 U.S.-headquartered public companies (excluding the financial sector). The results form the inaugural CFO/REL Cash Masters Scorecard.

Gauged by standard metrics, 2006 was a good year for the top 1,000 companies. Sales increased 10.2 percent, to $8.9 trillion; operating cash flow rose 9.4 percent, to just over $1 trillion; and cash on hand grew by 1.2 percent, to $574 billion (the latter is admittedly a comedown from 2005's spectacular 11 percent growth). By year-end 2006, according to REL, the top companies had accumulated some $351 billion in "excess" cash (more on this below).

But good as this glass-is-overflowing news is, it could have been better. Cash conversion efficiency (CCE), a measure of companies' ability to turn sales dollars into cash, declined for the top 1,000 companies between 2005 and 2006, from 11.5 percent to 11.4 percent. CCE is simply operating cash flow divided by sales; the lower it is, "the fewer dollars are making their way to the balance sheet," says Stephen Payne, president of REL.

Meanwhile, when measured as a percentage of sales, corporate cash on hand actually fell 8.1 percent in 2006, to 6.5 percent. That development does have a positive aspect, since it indicates that companies are putting more of their fat cash cushions to work. But the decline can also be attributed in part to worsening CCE.

The Cash Masters Scorecard shows how companies stack up against their industry peers measured by CCE performance. The scorecard, says Payne, can help finance chiefs see what opportunities their companies have to generate additional cash flow from operations — whether, for example, through lowering selling, general, and administrative (SG&A) costs, redesigning working-capital processes, deploying new technology, or using low-cost sourcing.

Leaders of the Pack

There is considerable CCE variability among industries. High-margin sectors, such as biotechnology and pharmaceuticals, will have high cash conversion efficiency, while low-margin industries, such as food and staples retailing, will have low CCE. In terms of CCE improvement, gas utilities, independent power producers and energy traders, and multi-utilities led the pack in 2006. Gas utilities achieved their 69 percent improvement over 2005 by reducing SG&A costs and net working capital, says Karlo Bustos, financial analyst at REL. Independent power producers and energy traders reduced SG&A and working capital as well, but also enjoyed an increase in gross margins of 84 percent.

Trailing the pack in CCE improvement were household durables, marine, and electronic equipment and instruments. Hit hard by the housing slump, the household-durables industry, which includes homebuilders such as Toll Brothers Inc. (2006 CCE: –2 percent), Beazer Homes USA Inc. (–6 percent), and Hovnanian Enterprises Inc. (–11 percent), saw its average CCE fall 33 percent in 2006, after a 10 percent decline the previous year. (Embattled Beazer announced in November that it had cut a quarter of its workforce and was suspending its stock dividend. Yet a larger-than-expected cash position of $460 million kept Beazer's stock price from falling further.) Gross margin for the industry dropped 5 percent, SG&A increased 4 percent, and net working capital grew 8 percent.

How does REL arrive at the whopping figure of $508 billion in forgone cash flow? It simply projects what would result if all of the companies in the scorecard matched the CCE of the highest performers in the appropriate industries. "It's a theoretical number," concedes Payne. "But why can't everyone else achieve upper-quartile performance? It's not like we're saying world-class [performance], or top 10 percent. What if companies achieved only half of what the upper quartile achieved? That's still a lot of money."

Rising Spirits

The decline of cash on hand as a percentage of sales is, again, a bad news/good news trend. Less cash is due on the one hand to lower CCE, but on the other hand to rising capital expenditures. Indeed, capex for the largest companies rose 21.5 percent in 2006, to $540 billion, reports REL, compared with 15.4 percent in 2005.

One company that has both efficiently generated cash and put it to work is Brown-Forman Corp., a Louisville-based maker of premium spirits and wines, including brands like Jack Daniel's whiskey and Southern Comfort liqueur. The company, with sales of $2.8 billion, ranked second on the scorecard in the beverages industry with a CCE of 18 percent for fiscal 2006. Strong operating cash flow and sizable cash on hand, as well as additional debt, enabled Brown-Forman to spend $58 million on capex, $143 million on dividends, and more than $1 billion on acquisitions in fiscal 2007. (Brown-Forman's CCE declined in fiscal 2007, to 16 percent, but remained robust for the industry.)

"We greatly value the financial flexibility that our cash level provides us," says Phoebe Wood, vice chairman and CFO. Brown-Forman plans to ramp up capex in 2008 to $70 million to $80 million, expanding its production and distribution capacity and investing in information technology and systems. All will be funded with cash from operations, says the company.

Despite Brown-Forman's spending, its cash as a percentage of sales rose from 17 percent in 2005 to 24 percent in 2006, bucking the overall trend for the top 1,000 companies. Wood says the company's "substantial growth in overseas markets" is partly responsible for the run-up in cash.

Too Much of a Good Thing?

Shareholders and CFOs may have different notions about how much cash companies should have on the balance sheet (see "The Cash Trap," November). But REL offers a way to calculate excess cash. By definition, it says, the quartile of companies in each industry with the least amount of cash on hand (as a percentage of sales) do not have excess cash. The remaining companies do, by the amount exceeding the cash held by the lowest performers in the top quartile.

Accordingly, REL figures that the level of excess cash held by the top 1,000 companies grew 9.5 percent in 2005 and 1.7 percent in 2006, to $351 billion. If companies in the bottom quartiles eliminated their excess cash, the return on capital employed for the top companies could increase from 15.8 percent to 16.7 percent. (Company and industry data for excess cash can be found in the complete scorecard.)

"I have long held the view that cash is king," says Wood of Brown-Forman. Other finance chiefs surely share her view, especially in these unsettled times. But as the Cash Masters Scorecard shows, companies may not be generating as much cash from sales as they should. And as the scorecard also suggests, companies may not need to hold on to quite as much cash as they think.